Tapping into your home’s equity is possible in a few ways. The most common is the fixed rate home equity loan or the home equity line of credit. Both loans have their pros and cons. We’ll run through them here so you can decide which option is right for you.
What is a Fixed Rate Home Equity Loan?
A fixed rate home equity loan is a closed-end loan. In other words, you receive the money as one lump sum payment. It is not a revolving debt. Once you take the funds, the loan is closed, much like your first mortgage. The home equity loan uses your home as collateral, just like your 1st mortgage.
The loan carries a fixed interest rate, which you pay for the next 5 to 30 years, depending on the loan’s terms. You make the same payment every month, which consists of principal and interest. The interest rate never changes and neither does your payment, though.
What is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, is a revolving debt. It’s still tied to your home, but you can reuse the funds as you pay them off. You are able to do this during the draw period. Generally, it’s the first 10 years of the loan.
A major difference with the HELOC is the interest rate. Unlike the home equity loan, the rate isn’t fixed. It’s a variable rate that changes monthly. Even though you make interest-only payments in the beginning, you’ll never know how much interest you’ll have to pay.
Here’s how it works. Let’s say you have a line of $20,000. You only use $5,000 of it at first. This leaves you with a $15,000 credit. You’ll pay interest on that $5,000 balance based on the current interest rate of each month. Some months your payment may increase and others it may decrease.
As you pay back the $5,000 your available balance increases. You are free to use that balance any time during the 10 years. Even if you use the entire amount, as you pay the principal back, you can reuse the funds.
During the draw period, you only have to make interest payments on the money you withdrew. After the draw period ends, you’ll make fully amortized payments. The principal is usually divvied up over the next 20 years. At this time, you are in the repayment period; you can’t draw any funds any longer.
Making the Right Choice
Now comes the hard part. How do you decide between a home equity loan and line of credit? No two borrowers will have the same answer. It depends on the situation. Here are a few examples:
- If you only need funds for a single purpose, such as paying for a new roof, the home equity loan may suffice. If you don’t see a need for funds in the near future, stick with the home equity loan. This way you begin paying principal and interest right away, gaining equity back in your home.
- If your need for funds is more staggered, you may want a HELOC. This way you have the funds available at the time you need them. Paying for a series of home improvements or college tuition are good examples of staggered payments.
- If you have credit card debt, generally, a home equity loan suits the situation. You borrow one lump sum to pay the debts off and pay less interest. If you don’t touch your credit cards again, you’re in good shape.
To help you figure out which option works for you, consider the answers to the following questions:
- How do you need the money? Is it one lump sum or more spread out?
- Do you see a future need for funds?
- Can you afford a principal and interest payment?
- Would the temptation of an open line of credit be too much?
- What’s the difference in interest rates between the two loans?
These answers can help you determine which option would work best for you. Most importantly, you should determine if you can afford the principal and interest payment right now. If you can’t, a fixed rate home equity loan wouldn’t be a good option. But careful thought should be given to the HELOC too. The principal and interest payment will become reality before you realize it.
Another important consideration is the temptation of an open line of credit. If you would use the line just because it’s there, it may not be the best option. A closed-end loan would give you the funds you need and nothing further. There’s no temptation to overspend and put yourself in debt, then.
Know Your Options
If you opt for the home equity line of credit, you have options. Once you use a portion of the line, you can ask that the lender freezes it. This means they lock in a specific rate for you on that portion of the loan. You won’t be able to use those funds again, but you’ll gain the benefit of a locked in rate rather than a variable rate.
Both the fixed rate home equity loan and home equity line of credit can be beneficial. It just depends on your needs. Discuss your various options with your lender. You can then weigh the pros and cons of each loan choice. You may also want to discuss the options with your tax advisor. Both loans offer the chance to write off your interest on your taxes, but you may not be able to write off 100% of it.
Both the home equity loan and line of credit can help you get the funds you need at an affordable interest rate.